Analysis: A Dirty Little Secret about Microcap Stock Valuations

An astounding seven of eight Reg A+ IPO stocks are underwater from their pricing levels. Some are down modestly while others like Adomani and Myomo are down more-than 50% – all while the broader market has barreled ever higher.

There are clearly multiple factors at work behind the Reg A+ share slide. To name a few: there’s a lack of analyst coverage; short sellers have hit most of the stocks aggressively; some investment bankers may have focused on short-term fees; and of course some of the companies just aren’t good investments.

But as some portfolio managers point out, microcap companies have always traded at a discount to their more mature counterparts. Consider M&A deals among U.S. companies across different valuation buckets over the last decade. Companies that sold for less than $25 million sold at an average enterprise value of 13.7 earnings before interest, taxes, depreciation, and amortization, according to Dealogic. As deal valuation increases, so does the multiple, up to 18.4 times for deals between $1 billion and $5 billion.

Why? A key reason is that it’s difficult to make the transition from a thriving mom- and-pop enterprise to a real business. A restaurant with a handful of locations, for instance, will need to centralize operations and make smart new hires before it can operate a dozen. The odds of a major business mistake, in turn, go up. The lesson isn’t that Reg A+ companies are overpriced. Rather, investors should do their homework before placing any big bets.